Understanding a Bank’s Financial Statements

Understanding banking financial statements is a complicated task. A classic bank’s business model is quite simple. However, a modern bank’s balance sheet can be challenging to understand because of the complex asset types they deal with today. Our finance tutors at GraduateTutor.com tutor several courses related to banking and financial institutions. Here are some of the things we can help you understand. 

A Classic Bank’s Business Model

A classic bank’s business model is quite simple. A bank raises money by offering savings and deposit account services to customers. Customers hand over spare cash to banks (place it in savings accounts or deposits) to earn interest on their cash. Let us assume that the interest offered is 4%. So, the bank paid customers $4 for every $100 they placed in the bank. 

The banks use the cash received from their deposit customers to lend to businesses at a higher interest rate. Let us assume that the interest received from businesses on loans is 7%. So, the bank receives $7 on every $100 it loaned customers.

Since the bank received $7 in interest income and paid out $4 in interest expense, it has a gross profit of $3, which covers its operating costs. Operating costs for a bank include rent, salaries, technology, marketing, etc. The difference between the interest income and interest expense is called the net interest income. The difference between the two interest rates is called the net interest spread.

Other Operations of Banks

Modern banks, however, have more complex business models. Banks provide a variety of service operations and gain revenues from multiple income streams. Some of the income streams, in addition to the net interest spread, include:

  • Fees: Banks charge various fees for their services. These fees include account maintenance fees, overdraft fees, ATM fees, transaction fees, etc. 
  • Trading: Banks engage in various trading activities on which they hope to profit.
  • Wealth/Asset Management Services: Banks offer asset management and advisory services, earning fees or commissions from managing client portfolios.
  • Foreign Exchange Services: Banks provide foreign exchange services to individuals and businesses, buying and selling currencies at different rates, contributing to their profits.
  • Credit Card Services: Banks issue credit cards and earn money through interest charges on unpaid balances, annual fees, late payment fees, and transaction fees charged to merchants.
  • Securitization: Banks may bundle loans (such as mortgages or auto loans) and sell them as securities to investors.
  • Credit facilities: Banks offer a variety of credit facilities, such as revolvers, Letters of Credit, Trade Credits, etc., on which they charge fees. 

Key Banking Metrics to Review First

When evaluating a bank, some key metrics we look for in a bank’s financial statements are:

  • Revenues
  • Expenses
  • Assets Under Management
  • % of Revenues by activity/category/Geography
  • % of profits by activity/category/Geography
  • Growth rates by activity/category/Geography
  • % of Assets by category
  • % of Liabilities by category
  • Interest Spread
  • Expenses/Revenues
  • Provisions for Losses
  • Non-Performing Assets + 90 days past due
  • The average cost of deposits
  • Average interest rate on loans
  • Net Charge offs by year

Banking Specific Ratio Analysis to Understand a Bank’s Financial Health

You can use ratio analysis to understand a bank’s financial health just like you would use ratio analysis to understand any other company’s financial health. However, some banking industry ratios are more important to understand and analyze when reading and understanding a bank’s financial statements. 

  • Loans/Deposits
  • Non-Performing Assets/Total Assets
  • Non Performing Assets+Past Due/Total Assets
  • Non-Performing Loans/Total Loans
  • Loan Loss Reserves/Non-Performing Loans
  • Net Charge offs/Average Loans
  • Loan Loss Reserves/Net Charge offs
  • Tangible Equity/Tangible Assets
  • Tier 1 Capital/Tangible Assets
  • Tier 1 Capital/Total Assets
  • Tier 1 Capital/Risk Weighted Assets
  • Leverage Ratio
  • Risk-Based Capital Ratio
  • Expense Ratio
  • Assets in Foreign currency/Domestic currency
  • Liabilities in Foreign currency/Domestic currency

Valuing a Bank

A bank’s ownership interest or share is an asset like any other, so it can be valued like any other asset. Its intrinsic value can be arrived at using DCF valuation. You can also use a relative valuation approach using industry multiples. 

Bank Valuation using P/E multiples

The P/E multiple is a workhorse used to value businesses across industries. It is commonly used because it is easy to understand and apply. The P/E multiple shows how much investors will pay for $1 of a business’s earnings. So, we compute the P/E multiple for similar companies (similar geography, business model, size, strategy, etc.) to understand how much investors are willing to pay for $1 of a similar business’s earnings. We take the average of these P/E multiples and apply it to our bank’s earnings. Remember that multiples are a quick and easy way to value a company/stock but multiples valuations does have some drawbacks which are addressed here.

Bank Valuation using P/TBV multiples

The P/TBV multiple is a banking-specific multiple. It stands for Price/Tangible Book Value.  A bank’s book value is its Assets minus Liabilities or the total Shareholders’ Equity balance in a balance sheet. The Tangible Book Value removes the intangible assets, such as goodwill, patents, etc., that appear on the bank’s balance sheet. 

The P/TBV multiple shows how much investors are willing to pay for $1 of a business’s tangible book value. So, we compute the P/TBV multiple for similar banks (similar geography, business model, size, strategy, etc.) to understand how much investors are willing to pay for $1 of similar businesses’ earnings. We take the average of these P/TBV multiples and apply it to our bank’s tangible book value. 

A P/TBV of 1 means that the bank is worth as much as the book value of its tangible assets. On the other hand, a P/TBV greater than 1 indicates that investors are willing to pay more than the book value of tangible assets for some reason. Since valuation is forward-looking, investors factor in potential growth and profitability when determining the value to pay for a stock. A P/TBV less than 1 suggests that investors are willing to pay less than the book value of their tangible assets for some reason. The reasons here could be they doubt the quality of the bank’s TBV or worry about potential losses that can be incurred, etc. 

Regulatory Levers Governments Use

Banks are economically important institutions in an economy. They play a central role in the functioning of an economy, and bank failures can have devastating consequences for the economy and the public at large. So, governments establish standards, oversight, and reporting requirements to protect the banks, depositors, and the public at large. These standards revolve around the following:

  • Capital requirements
  • Liquidity requirements
  • Overall risk management
  • Resolution plan and credit exposure reporting requirements
  • Concentration limits
  • Other standards deemed appropriate, including but not limited to contingent capital requirements

Capital Requirements For a Bank

Governments prescribe capital requirements standards for banks to ensure that depositors have access to money at all times. These regulatory capital requirements standards usually take the form of minimum capital ratios that the banks must maintain at all times. 

The most commonly used capital requirement ratio is the Common Equity Tier 1 ratio. The term Common Equity Tier 1 (CET1) refers to of common shares and retained earnings of a bank. The term Common Equity Tier 1 is looked at in relation to the risk-weighted assets of a bank. 

Ratios are also set based on other defined tiers, such as  Tier 2 and additional Tier 1 ratios. 

Additional Tier 1 includes certain hybrid securities to tier 1, such as trust-preferred securities. Tier 2 Capital includes hybrid securities and subordinated debt.

Estimating A Banks Risk-Weighted Assets

Not all assets are equally risky. Some assets have a higher risk of losing value than others. The risk-weighted asset of a bank is the total assets weighted by the riskiness of each asset. 

A lower risk-weighting is applied to safer assets and a higher risk-weighting is applied to safer assets. For example, Government bonds carry a 0% risk weight. Assets like secured loans carry a risk weight of 35%. Other assets like unsecured loans have a risk weight of 50%, etc. 

A simple example would look like this. So if a bank had $100 of U.S. Government bonds, $100 of secured loans, and $100 of unsecured loans on its balance sheet, its total risk-weighted assets would equal $85 (0% × $100 + 35% × $100 + 50% × $100)

Liquidity Requirements for a Bank

Governments also institute other constraints on banks. Two common restrictions banks are expected to adhere to are specified Maximum Leverage Ratios and Net Stable Funding Ratios.

Stress Tests for a Bank

A stress test for a bank is simply a test to see if a bank will survive a difficult market situation. A bank needs sufficient capital to survive a challenging market or economic shock. So, a stress test is a test to check if a bank is adequately prepared to deal with adverse market conditions. 

A bank’s stress test usually involves modeling or computing how much a bank’s assets and liabilities may change in an adverse situation and how the bank will fare in such a condition. Will it be able to weather the situation, or will it collapse and fold? 

The central bank or government authority will provide the framework for banks’ stress tests. It determines how much a bank’s assets and liabilities need to be modeled under different scenarios. The central bank specifies the loss rates of different assets and liabilities a bank has and specifies how much capital of different types must be kept aside by the banks to cover loan losses, etc. 

  • Step 1: Loan default rates are higher during a period of economic difficulty, so the stress test tries to determine how much a bank’s loan will default in step 1. We use the loan default rates specified by the Federal Reserve to estimate loan losses. 
  • Sep 2: Find out how much the bank has provided to deal with loan losses due to default. This is also known as Loan Loss Reserves. 
  • Step 3: Loss Reserve Excess: Compare Step 1 and Step 2 to see if the bank has provided sufficient reserves to deal with the loan losses. If the reserves set aside by the institution exceed the estimated loan losses, we have a “loss reserve excess.” 
  • Step 4: if we do not have a loss reserve excess, we have a shortfall in reserves that needs to be covered by the tier 1 capital. 

Types of Risks a Bank Faces

The banking industry faces a few unique risks. Here is a broad outline of the different types of risks a bank faces.

Credit Risk:  Credit risk is the risk of a loss due to a borrower failing to repay a loan or to satisfy loan obligations. You can quantify and evaluate a bank’s credit risk using various methods, including calculating average credit score for borrowers, KMV methodology, average credit rating, etc. You can also look at the estimate of bad loans/non-performing loans and look at non-performing loans or 90 days past due as a percentage of total loans, etc. Comparing these numbers with peers/comparable banks will show you credit risk levels relative to the industry or with historical numbers to gauge the current risk levels. 

Interest rate risk: Interest rate risk is the potential for investment losses that can be caused by an upward move in interest rates. When interest rates move up, the discount    rates increase causing the value of assets to go down. This will cause many assets to be revalued in the balance sheets causing huge losses. These losses even if “unrealized” in theory can cause ripple effects in the industry. 

You can quantify this risk by looking at the change in values of assets and liabilities for a 1% increase in interest rates. 

Duration Mismatch: A bank’s business model relies on borrowing short-term and lending long-term. So, its liabilities have shorter durations than its assets. This causes a potential risk because when interest rates rise, the short-term liabilities are first impacted, increasing costs and squeezing the bank’s profits. 

You can quantify the risk from mismatched duration by computing the duration of assets and duration of liabilities. 

Exchange rate risk: Exchange rate risk refers to the risk that a company’s operations and profitability may be affected by changes in the exchange rates between currencies

You can quantify exchange rate risk by looking at the percentage of assets and liabilities that are in local currency based against foreign currency. 

Market risk: Market risk is the possibility that the bank will lose money in its market operations. Banks indulge in a variety of market operations, such as investing in short-term deposits, longer-term bonds, equities, hedging activities, etc. The results of these market operations will impact the bank’s financial performance and carry risk. 

You can quantify this risk by looking at measures such as value at risk (VAR), expected losses, etc. Another measure can be the correlation of assets and liabilities returns/values.

Liquidity risk: Liquidity risk refers to the potential difficulty an entity may face in meeting its short-term financial obligations. For a bank, this is primarily meeting its depositor’s request to withdraw their funds. This happens if there is a sudden surge to withdraw funds and the bank is unable to convert its assets into cash to pay depositors or has to do with a significant loss.

You can look at the liquidity risk of a bank by looking at its cash reserves and capital sufficiency ratios.

Operational: Operational risk is the risk of losses caused by flawed or failed processes, policies, systems or errors. This also includes events that disrupt business operations such as natural disasters, criminal activity such as fraud, etc. 

Key Terms In Reading a Bank’s Financial Statements

Allowance or reserves or provisions for credit losses: An estimated expense added by banks in the income statement to provide for possible defaults by loan customers. This also includes losses anticipated for any other creditors of the bank. In the balance sheet, loan assets are reduced by the balance of the allowance or reserves or provisions for credit losses. Each year this balance is the beginning balances plus provision for loan/credit losses for this year less net write-offs or charge-offs.

Charge-offs or write-offs: Debt owed to the bank being written off as unlikely to be paid/forgiven. 

Net interest income: This is the net of interest income earned by the bank and interest expense paid by the bank. 

Net interest margin (NIM): The net interest income divided by average earning assets (e.g., loans, mortgage-backed securities, other securities).

Non-performing assets (NPA): Loans in which the borrower has not paid the principal and interest payments due for 90 days or more. 

Interest rate spread: The difference between the interest rate earned by banks on their loans and the interest rates paid to depositors by the bank. 

Tier 1 capital: Common shares, retained earnings, other comprehensive income, and qualifying minority interest.

Finance Tutoring to Understand How to Read and Interpret a Bank’s Financial Statements

This will give you a quick introduction. The real learning comes when you start analyzing banks and compare banks within one geography first and then across the globe. Study one bank a day for 30 days and you will know more about banks than 99 percentile of the population. Let us know if our graduate level finance tutors can help.

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